What type of CFC income is taxed in the United States?

Subpart F Income 

Subpart F income is a certain type of foreign income that is immediately taxable in the U.S., even if it hasn’t been distributed to shareholders. This rule, part of the IRC’s Subpart F provisions, aims to prevent U.S. taxpayers from deferring taxes by keeping specific income within CFCs. Categories of Subpart F income include: 

• Foreign Base Company Income (FBCI) – $954

  This is the largest category and includes several subcategories:

  • Foreign Personal Holding Company Income

    Foreign Personal Holding Company Income includes passive income, such as:

    • Dividends.
    • Interest.
    • Rents and royalties (with some exceptions).
    • Capital gains from property producing such income.
  • Foreign Base Company Sales Income

    Foreign Base Company Sales Income includes income from buying or selling goods:

    • Purchased from or sold to a related party, and
    • Manufactured, produced, or used outside the CFC’s country of incorporation.
  • Foreign Base Company Services Income

    Foreign Base Company Services Income includes income from services:

    • Performed for or on behalf of a related person, and
    • Performed outside the CFC’s country of incorporation.
  • Foreign Base Company Oil-Related Income

    Foreign Base Company Oil-Related Income includes income related to oil exploration, drilling, or mineral extraction, with specific definitions and exceptions.

• Insurance Income – $953

  Generally, insurance income, as defined in section 953(a), is included as Subpart F income by a foreign insurance company qualified as CFC.

  Under Section 957(b), foreign insurance companies are considered CFCs when 

  • U.S. shareholders own more than 25% of the company; and 
  • The company gets more than 75% of its total premium income from reinsurance or from issuing insurance/annuity contracts that don’t qualify as exempt contracts under section 953(e)(2).  

  Section 953(a) defines “insurance income” as any income generated by a Controlled Foreign Corporation (CFC) that arises from issuing or reinsuring insurance or annuity contracts. This income would be taxable under Subchapter L if it were earned by a domestic insurance company.

• International Boycott Factor Income – $999

  Income derived by U.S. Shareholders from operations in countries that are internationally boycotted from doing business.

• Illegal Bribes, Kickbacks, or Other Unlawful Payments – §952(a)(4)

  Any bribes, kickbacks or illicit payments made to a an official or employee of a foreign government in violation of U.S. laws such as the Foreign Corrupt Practices Act (FCPA).

• Income from Countries Under U.S. Sanction – §952(a)(5)

  Income from doing business in countries that the U.S. government has identified as supporting terrorism or being otherwise restricted (formerly known as “Section 901(j)” countries).

Understanding Subpart F Through a Simple CFC Example

John and Sarah are U.S. citizens. Both are shareholders of a foreign holding company ABC Ltd. Here John owns 60% of ABC Ltd, while Sarah owns 9% of ABC Ltd.  

ABC Ltd. qualifies as a CFC because U.S. shareholder John owns more than 50% of the total voting power. John is considered a U.S. shareholder under Subpart F rules since he owns more than 10%. Sarah, owning only 9%, does not qualify as a U.S. shareholder under Subpart F rules. For more understanding of CFC, please refer to the following article
In the current year, ABC Ltd. has generated its E&P (Earnings and Profit). In addition, the company primarily holds passive investments, such as stocks and bonds. Due to the passive nature of the income the E&P will come under Subpart F rules.  

Without Subpart F rules, John could indefinitely postpone the payment of U.S. taxes by keeping the earnings in ABC Ltd. and not distributing them. However, Subpart F prevents this tax deferral strategy: John must include his pro-rata share (60%) of ABC Ltd.’s Subpart F income in his current year U.S. taxable income, regardless of whether ABC Ltd. distributes the earnings. 

Sarah, not being a U.S. shareholder under Subpart F rules, is only taxed when she receives distributions from ABC Ltd. This demonstrates how Subpart F serves its primary purpose: preventing U.S. taxpayers from using foreign corporations to indefinitely defer U.S. taxation of mobile, passive income. 

Without the Subpart F rules, U.S. shareholders could accumulate substantial foreign earnings while deferring U.S. taxes until they choose to repatriate the income.